The Market Setting New Record-Highs Doesn't Mean You Should Stop Buying Great Companies
Tom Phelps, author of the great book "100 to 1 in the Stock Market," had a great quote about how long-term investing can allow you to achieve your financial dreams "Fortunes are made by buying right and holding on." But that's easier said than done, especially when the market appears, at least to many, to be melting up and in a bubble.
Thanks mostly to a Fed-induced "bad news is good news" rate cut rally, the S&P 500 is up 17.4% YTD and on track for its best June since 1955 (the Dow is poised to have its best June since 1938).
All told, the stock market is up between 14.5% and 21.1% YTD, depending on which index you look at. This means, that based on the S&P 500, the stock market is on pace for the best first half gains since 1997 (the tech bubble).
This strong rally is occurring at the same time as economic reports are showing slowing US and global growth and analyst estimates of earnings growth are falling rapidly.
Analysts now estimate that the S&P 500 is set for three consecutive quarters of negative EPS growth, the longest earnings recession in 10 years. 2019 EPS growth projections are down to just 2.8%, and that's far from certain to happen since Q4's 6.7% growth rate is looking less and less likely the longer the US/China trade war drags on.
And while analysts are now forecasting a decent 8.9% 12-month total return for the broader market, that assumes double-digit earnings growth (11.0% in 2020). The 2020 expected EPS growth rate is down 0.6% in recent weeks, most likely due to weakening macroeconomic conditions and lack of a definitive trade deal.
So with the S&P 500 now trading at 16.8 times forward earnings (vs. 16.2 25-year average) and fundamentals weakening, this means that investors should avoid putting new money to work in the market, right?
Actually, no. For one thing, the market being at record-highs is not abnormal, and certainly not a reason to avoid stocks.
Over the last 74 years, the stock market has spent 34% of its time at record-highs and 66% of the time within 10% of them. This is because stocks are a function of corporate earnings, cash flow, and dividends, all of which go up over time. This is why the S&P 500 finished up in 74% of years since 1926, and why we own stocks in the first place.
But it's also true that the higher valuation multiples climb (such as the forward P/E) the lower future returns are likely to be.
While valuations have little effect on 12-month returns (because in the short term, sentiment rules the Street) forward P/Es have a strong effect on forward 5-year total returns. Since 1994, 46% of 5-year total returns can be explained by the market's forward P/E.
With stocks now trading 4% above their historical norm (based on forward P/E), it certainly makes sense to consider your portfolio's asset allocation and potentially rebalance your mix of stocks/cash/bonds (generally a good idea every six to 12 months).
But as long as your portfolio isn't significantly overweight equities, today isn't necessarily a bad time to steadily put new discretionary savings (that you won't need for 5+ years) into stocks.
That's especially true if you're buying individual companies, dozens of which are still on sale and offering attractive long-term opportunities for both income growth and double-digit total returns.
This weekly watchlist series provides great investing ideas, based on my 186 company watchlist of blue-chip dividend stocks. Each of these is an 8+ on my 11 point quality scoring system and should provide both safe dividends during all market/economic conditions as well as market-beating returns if bought at a significant discount to fair value. But how can you know what quality blue-chips are on sale? Well, there are six time-tested methods I consider most useful.
Discounted Cash Flow
Fundamentally, any company is worth the present value of all its future cash flow. That's as basic a valuation method as you can get. However, in reality, the future is uncertain, and the discount rate you use, as well as your growth assumptions, can make a DCF model say pretty much anything you want.
This is why I consider Morningstar's 100% long-term, fundamentals-driven and conservative analysts to be a great source of DCF estimated fair values. Here are my watchlist blue-chips that Morningstar considers 5 star (very strong buys) and 4 stars (strong buys).
Those analysts generally assume slower growth than the analyst consensus and even sometimes management itself. They also take into account the uncertainty surrounding a company's business model/risk profile. Thus, 4- and 5-star rated companies offer a comprehensive margin of safety that potentially makes them good investments.
Note that the "Q" rated companies are quantitative models and slightly less reliable.
Want a more quantitative approach to DCF? Well, here are my watchlist stocks ranked by price/fair value, with each company at least 10% undervalued per Morningstar's intrinsic value estimate. Since all of my watchlist stocks are 8+ level quality blue-chips, a 10% discount to fair value is likely to make a great long-term income growth investment.
The lower the price/fair value estimate, the larger the margin of safety for investing.
But DCF is far from the only valuation method you should consider.
Remember that Yale valuation study that looked at stocks based on P/E ratio? Well, the venerable P/E ratio is one of the most popular valuation approaches, and for good reason. While no valuation method is perfect, a good rule of thumb (from Chuck Carnevale, the SA king of value investing and founder of F.A.S.T. Graphs) is to try not to pay more than 15 times forward earnings for a company. Chuck's historical P/E valuation approach has made him a legend on Seeking Alpha and, according to TipRanks, one of the best analysts in the country when it comes to making investors money.
Chuck usually compares companies to their historical P/E ratios, and he's ranked in the top 1.4% of all analysts tracked by TipRanks (based on the forward 12-month total returns of his recommendations). While 12 months is hardly "long term," the point is that Mr. Carnevale is a fantastic value investing analyst and his historical valuation-driven approach is beating 98.6% of all bloggers/analysts, including 5,200 that work on Wall Street.
Here are dozens of blue-chip companies with forward P/Es of 15 or less. Note that some industries are naturally prone to lower multiples (such as financials) due to more cyclical earnings. Also, P/E ratios for MLPs, REITs, and YieldCos are not a good indication of value since high depreciation results in lower EPS. Price/cash flow is the better approach with such pass-through stocks.
Note that stewardship rating is Morningstar's estimate of the quality of the management team. P = poor (my policy to avoid all such companies if I agree with Morningstar's assessment, which I don't on Altria (NYSE:MO)), S = standard (average to good), and E = exemplary (very good to excellent).
Price-To-Earnings/Growth (PEG) Ratio
A low P/E ratio might not necessarily mean a company is a great buy. For one thing cyclical companies can have highly volatile earnings which is why they tend to trade at lower multiples than more stable sectors. Another thing to consider is the long-term growth rate. A company with zero long-term growth potential deserves to have a P/E of 7.9 (according to a formula developed by Benjamin Graham, Buffett's mentor and the father of value investing).
That's why another popular valuation metric is the PEG ratio, which divides the P/E ratio by the expected long-term growth rate. A PEG ratio of 1.0 to 3.0 is usually a good rule of thumb, depending on the quality of the company, how stable its growth has been over time, and the sector (REITs, for example, are a slow-growing sector with naturally higher PEGs).
But in general, the lower the PEG ratio, the more likely you are to be getting a good value. The S&P 500's PEG (forward P/E/long-term expected EPS growth) is currently 16.8/6.1% (18-year-average) = 2.8. Here are my watchlist stocks with PEG ratios of 2.0 or less.
While earnings are usually what Wall Street obsesses over, it's actually cash flow that companies run on, and use to pay a dividend, repurchase shares and pay down debt. Thus, the price/cash flow ratio can be considered a similar metric to the P/E ratio, but a more accurate representation of a company's value. Chuck Carnevale also considers a 15.0 or smaller price/cash flow ratio to be a good rule of thumb for buying quality companies at a fair price. Buying a quality company at a modest to great cash flow multiple is a very high probability long-term strategy.
Here are all the companies in my watchlist with price/cash flows of 15.0 or less.
Blue-Chips Near 52-Week (Or 5-Year) Lows, aka "Fat Pitch Blue-Chips"
I maintain a watchlist that takes every company I track and applies an 11-point quality score based on dividend safety, the business model, and management quality. All dividend stocks can be ranked 3-11, and my watchlist (186 companies and growing slowly over time) only includes those with quality scores of 8 and higher.
- 8: Blue-chip (buy a modest discount to fair value) limit to 5% to 10% of your portfolio.
- 9 to 10: SWAN stock: buy with confidence at fair value or better, limit to 5% to 10% of your portfolio.
- 11: Super SWAN (as close to an ideal dividend stock as you can find on Wall Street) limit to 5% to 10% of your portfolio.
The 27 Super SWANS on my Watchlist
I've programmed that watchlist to track prices and use the 52-week low as a means of estimating a target price at which a blue-chip or SWAN stock becomes a Buffett-style "fat pitch" investment. This means a blue-chip/SWAN stock is:
- Trading near its 52-week (or often multi-year) low.
- Undervalued per dividend yield theory (more on this in a moment).
- Offers a high probability of achieving significant multiple expansion within 5 years and thus delivering double-digit long-term total returns over this time period.
Another method you can use is to target blue chips trading in protracted bear markets, such as sharp discounts to their 5-year highs. Buying a company at multi-year lows is another way to reduce the risk of overpaying and boost long-term total return potential.
Basically, "Fat Pitch" investing is about achieving high-risk style returns with low-risk stocks, by buying them when they are at their least popular ("be greedy when others are fearful.")
Dividend Yield Theory: Market-Beating Blue-Chip Returns Since 1966
This group of dividend growth blue chips represents what I consider the best stocks you can buy today. They are presented in 5 categories, sorted by most undervalued (based on dividend yield theory using a 5-year average yield).
- High yield (4+% yield)
- Fast dividend growth
- Dividend Aristocrats
- Dividend Kings
The goal is to allow readers to know what are the best low-risk dividend growth stocks to buy at any given time. You can think of these as my "highest-conviction" recommendations for conservative income investors that represent what I consider to be the best opportunities for low-risk income investors available in the market today. Over time, a portfolio built based on these watchlists will be highly diversified, low-risk, and a great source of safe and rising income over time.
The rankings are based on the discount to fair value. The valuations are determined by dividend yield theory, which Investment Quality Trends, or IQT, has proven works well for dividend stocks since 1966, generating market-crushing long-term returns with far less volatility.
According to Hulbert Financial Digest, IQT's pure blue-chip + DYT approach has resulted in the best 30-year risk-adjusted total returns of any US investing newsletter (over 200 are tracked).
That's because, for stable business income stocks, yields tend to mean-revert over time, meaning cycle around a relatively fixed value approximating fair value. If you buy a dividend stock when the yield is far above its historical average, then you'll likely outperform when its valuation returns to its normal level over time.
For the purposes of these valuation-adjusted total return potentials, I use the Gordon Dividend Growth Model or GDGM (which is what Brookfield Asset Management (BAM) and NextEra Energy (NEE) use). Since 1954, this has proven relatively accurate at modeling long-term total returns via the formula: Yield + Dividend growth. That's because, assuming no change in valuation, a stable business model (doesn't change much over time), and a constant payout ratio, dividend growth tracks cash flow growth.
The valuation adjustment assumes that a stock's yield will revert to its historical norm within 10 years (over that time period, stock prices are purely a function of fundamentals). Thus, these valuation total return models are based on the formula: Yield + Projected 10-year dividend growth (analyst consensus, confirmed by historical growth rate) + 10-year yield reversion return boost.
For example, if a stock with a historical average yield of 2% is trading at 3%, then the yield is 50% above its historical yield. This implies the stock is 3% current yield - 2% historical yield)/3% current yield = 33% undervalued. If the stock mean-reverts over 10 years, then this means the price will rise by 50% over 10 years just to correct the undervaluation.
That represents a 4.1% annual total return just from valuation mean regression. If the stock grows its cash flow (and dividend) at 10% over this time, then the total return one would expect from this stock would be 3% yield + 10% dividend (and FCF/share) growth + 4.1% valuation boost = 17.1%.
The historical margin of error for this valuation-adjusted model is about 20% (the most accurate I've yet discovered).
Top 5 High-Yield Blue-Chips To Buy Today
Top 5 Fast-Growing Dividend Blue-Chips To Buy Today
Top 5 Dividend Aristocrats To Buy Today
Top 5 Dividend Kings To Buy Today
Bottom Line: The Market May Be At Record-Highs, and Slightly Overvalued, But Plenty of Great Blue-Chips Are Still On Sale
It might seem logical to avoid buying stocks at record-highs. But history is clear that this is a bad long-term plan. Despite the S&P 500 being on track for its best first half in 22 years, the market is merely 4% overvalued today, according to its forward P/E ratio vs. the 25-year average.
Thus market timing is a risky move, because as Peter Lynch (the 2nd best investor in history, 29% CAGR total returns from 1977 to 1990) once said
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves...The key to making money in stocks is to not get scared out of them.”
Rather than trying to outsmart the market, long-term income investors are best off merely trying to be "not stupid," at least according to Charlie Munger, legendary value investor and Buffett's right hand at Berkshire (BRK.B) (NYSE:BRK.A) for decades.
It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."
Ultimately, market-timing well and consistently over time is all but impossible, even for Wall Street pros. Here's what Jack Bogle, founder of Vanguard, said about market timing.
Sure, it'd be great to get out of stocks at the high and jump back in at the low, but in 55 years in the business, I not only have never met anybody who knew how to do it, I've never met anybody who had met anybody who knew how to do it."
My goal with this weekly series is to point out great long-term undervalued blue-chip dividends stocks. You can mix and match whatever valuation approaches you want (that's what I do when deciding what to buy each week).
Ultimately, the goal of all investors should be to follow a Munger/Buffett like "consistently not stupid" approach. Buying quality companies, with good to great management, at good to great prices, is the easiest way I know of to do that, and generate generous, safe and exponentially growing income and wealth over time.